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					Bringing Kyoto to Market

Carbon as a Commodity: UK and
   International Perspectives
 CBI Conference Centre, Centre Point, London
             February 21, 2002
               Frank Joshua
             Managing Director
                      Overview
• The International Policy Context
• The Emerging Global Emissions Marketplace
  –   Key features of projects and trades (to date)
  –   First trades of compliance instruments
  –   Recent market prices
  –   Key features of carbon transactions
  –   Characteristics of successful commodity markets
• Unfinished Business
  – Harmonizing domestic systems
  – Standardizing the commodity
  – Ratifying Kyoto
The International Policy Context
           From Rio to Marrakech:
        International Climate Process                                             Marrakech
                                                                                   Accords
                                                                      The         Trading Rules,
                                                                                   CDM Board,
                                                                     Hague &        Rules for
                                        Kyoto         Buenos          Bonn           Sinks &
                                       Protocol        Aires          Political    Compliance
                         Geneva        Differentiated  Plan          Agreement
                                                                                     2001
                                                      Schedule for
                        Declaration      Targets,
                                                       Guidelines
                                                                     2000-1
                          Binding       Trading &
           Berlin       Targets with        CDM         1998
          Mandate        Maximum
 Rio       Inadequate    Flexibility     1997
Treaty    Commitments
1990 by                    1996
  2000
            1995
 1992
Advent of a Carbon Constrained Economy
    The First Ten Years & Beyond
                                                               Ratification &
                                                   COP7      Entry into Force of
                                        COP6+    Marrakech
                                         BONN                 Kyoto Protocol ?
                                                  Accords
                                          July   Nov 2001
UNFCCC
                       COP3        COP6 2001                                    The first
Rio Earth   COP 1    The Kyoto   The Hague                     Review of      commitment
 Summit     Berlin    Protocol    meeting                      Progress          period


  1992      1995       1997        2000              2002         2005       2008 - 2012


                                 Domestic Emission
                                  Trading Schemes
                                                             Regional ETS
                              Denmark - January 2001
                                                              EU Scheme
                                   UK - April 2002
    Emissions Trading: Some Early
            Policy Issues
•   Emissions Trading seen as “US concept”
•   Little or no non-US experience
•   No “Proof of Concept” (prior to 1997)
•   Trading Pollution seen as “Immoral”
•   Cost of Carbon unknown
•   Serious Economic, Social, Cultural and
    Environmental implications
          The Kyoto Protocol
• Establishes legally binding GHG emission caps
  for developed countries: 5.2% below 1990
• Specifies Greenhouse Gases: CO2, CH4, N2O,
  HFCs, PFCs, SF6
• Establishes time frame for compliance (2008-
  2012)
• Defines mechanisms for carbon trading, namely:
  Emissions Trading, Joint Implementation, Clean
  Development Mechanism
• Defines Tradeable Commodities: AAUs, ERUs,
  CERs
• Envisages participation by Corporate Entities
        The Marrakech Accords
• Trading Rules Becoming Clearer
  –   Eligibility criteria to participate in the Flex Mecs
  –   Operational rules for ET, JI & CDM agreed
  –   CDM Executive Board established
  –   Rules for sinks clarified (creation of RMUs)
  –   Accounting rules for AAUs, CERs, ERUs, and RMUs
  –   Procedures for Registries and Banking
  –   Compliance two-step established
• Kyoto + Marrakech = International Policy
  Framework
• Requires Ratification of the Kyoto Protocol
The Emerging Global Emissions
        Marketplace
A GHG Market Is Emerging
First Trades of Compliance Instruments
• Dutch Emissions Reduction Procurement Tender
   – ERU-PT (April 2001): 4 mtCO2e
   – ERU-PT/2: 10 mtCO2e & CERU-PT: 3 mtCO2e
   – Purchase agreements with IFC: 10 mtCO2e
   – Similar deals expected with PCF and EBRD
• UK GHG Trading Program
   – DuPont - Mieco executed first GHG transaction of government-
     sanctioned instrument (10,000 tonnes of allowances)
   – UK auction: 215 million pounds to be auctioned over 5 years
   – First auction end-February 2002
• Danish Power Sector Cap & Trade Program
   – Three trades in late 2001
• Australian Government (GGAP) Program
   – A$100 million to be auctioned over 4 years
   – First auctions conducted in 2001
                         Recent Market Prices
             GHG Prices by Commodity and Vintage (U.S.$ per ton CO2E)



Com m odity Type                              Vintage Year        Price per ton CO2E (US$)
Verified Em ission Reductions ("VERs")
Annex B VERs                                      1991-2007                       $0.60-$1.50
Annex B VERs                                      2008-2012                       $1.65-$3.00
CDM VERs                                          2000-2001                       $1.75-$3.00
Em ission Reductions ("ERs")
ERs                                               1996-2012                       $1.00-$2.70
Com pliance Tools
Dutch ERUs                                        2008-2012                       $4.40-$7.99
Danish allow ances - Bid/Offer                    2001-2003                       $3.55-$4.14
UK permits - Bid/Offer                                 2002                       $6.44-$8.59
UK permit Call Option - Bid        2002 (expire 2/03 or 3/03) $12.03 (strike), $0.86 (premium)



                                                               Source: Natsource, 2001
Key Features of Carbon Transactions
    Tradable Commodity          Transaction Structures

Verified Emission Reductions     • Multi-year streams
                               • Forward transactions
                                 • Options (Call/Put)
                               • Procurement Tenders
Government Permits & ERUs
                                    • Direct Sales
                                   • Seller Liability
                                       • MOUs
  Candidate CDM Projects        • Multi-year streams
                               •Forward transactions
                                 •Options & Futures
                                    • Seller liability
                                • Insurance products
Key Features of Projects and Trades (to date)
     GHG Trades                       JI and CDM Projects
•   No standardized contracts –     • Uncertainty over credit
    buyers & sellers define units     streams
•   Time consuming to transact,     • Time consuming to transact,
    with high transaction costs       with high transaction costs
                                    • Relatively few projects
•   Relatively few trades & few
                                    • Credit streams have marginal
    participants
                                      impact on project viability:
•   Early transactions mostly in       – Energy eff. & District heating =
    VERs: 66 = 55mtCO2e                  2.0% IRR
                                       – Wind = 0.9 – 1.3%
•   Market shifting to national        – Hydro = 1.2 – 2.6%
    compliance tools (UK,              – Bagasse = 0.5 – 3.5%
    Denmark, Netherlands)              – Biomass & Municipal waste =
                                         5.0%+
     (Source: Natsource)               (Source: World Bank/PCF)
Characteristics of Successful
   Commodity Markets
     Five Elements of Successful
        Commodity Markets

•   Liquidity
•   Price Transparency
•   Standardisation of the Commodity
•   Multiple Buyers and Sellers
•   Existence of Market Makers / Speculators /
    Arbitrageurs
              Liquidity - in the SO2 Market
                 Cumulative SO2 Allowances Transferred
                Between March 1994 and September 2000




Source: EPA
Price Transparency is Developing
       for the SO2 Market
  GHG Emissions Market Pathway


                                            CCX               EU
                            EMDG                             Basrec
                                               Simulations
      PCF
               Fondelec          UK          (GETS, CO2e,
                                               Natsource)
          GERT         Denmark
                                   C-Tech Fund                          Acceptable
                            Aust                                           market
          BP   PERT        GGAP
                                                                       structure limit
               Shell

                Early Stage                          Mid Stage          Late Stage

 1997                  2001            2002      2003        2004 2005 2006 2007 2008
(Kyoto)
Time to Commoditization

                                                 Time taken for liquidity
                                                 (I.e. commoditisation)
                   5 years           CO2
                   (estimate)


                6 years            US SO2

           7 years              UK Electricity

     10 years                      UK Gas


15 years                        European Oil
Unfinished Business
 International Policy Challenges
• Harmonizing systems design among market
  leaders (EU, UK, Denmark, Netherlands,
  Norway, Canada)
• Fragmentation likely for the foreseeable future
• Commodity standardization could take many
  years
• Markets will address weaknesses – At a Cost!
• Entry-into-Force of the Kyoto Protocol –
  Timing is Everything!
Harmonizing Domestic Systems
Comparing UK and EU Trading Schemes
        The UK                               The EU

• Pilot trading scheme        • A mandatory cap & trade
  linked to CCLA                scheme
• Duration: 2002 - 2007       • Duration: 2005 - 2007
• Downstream energy users     • Covers direct C02 only
  (excl. households)
                                from: Energy activities; Ferrous
• Both cap & trade and           metal production and processing;
  baseline & credit              Mineral industry; Pulp and paper
• Gateway mechanism           • 4000 Installations will
• Covers six GHGs               require permit to emit CO2
• Financial incentive – 1st   • Carbon credits excluded
  auction end-Feb. 2002       • Market open to all
• Market open to all
UK Emissions Trading Scheme

Non-target
                            Trading market
 holders


                                              Gateway




                             Participants    Participants
   Projects                  with absolute   with relative
                                targets        targets




             Verification

             Reporting


              Emissions Trading Authority
EU Emissions Trading Scheme
Non-target
                             Trading market
 holders




                            Participants with
                             absolute CO2
                                 targets
                                                Free allowance
                                                   allocation


             Verification

             Reporting


 Member State Emissions Trading Authority
      Issues for Harmonization
• Clear Environmental Goals
• Design Architecture - Simplicity Works Best
• Minimize Transaction Costs
• Pay attention to Allocation (it can and will affect
  corporate valuations)
• Banking Rules can help or hinder early action
• Coverage (Gases, Sectors, Sequestration)
• Appropriate compliance regime, i.e. Penalties for
  non-compliance
Standardizing the Commodity
         Standardizing the Commodity:
            The EMDG Pilot Project
   Asset           Ownership
   Definition      rights

                                                        Common
Source of                                               Carbon
                Validity     Counterparty
Credit                                                  Credit Unit
                             risk
(AAU,CER
etc)

       Transferability     Delivery
                           risk


  Carbon Repository analyses and absorbs complex portfolio of
  risks – creating « Gold Standard » carbon credit
The EMDG Study: Key Findings
• Carbon Repository is technically feasible
  under certain conditions:
  –   Design and build Carbon Rating Engine
  –   Develop Market Risk Model
  –   Insurance products emerge
  –   Greater clarity on regulatory frameworks
• Timeline for commercial exploitation of the
  CR concept
           Pilot Portfolio Elements
Carbon
Rating                             More
Engine                            Carbon
                      Pilot       Prices
                     Carbon
Trading
                     Portfolio
Platform
                                 Insurance
                                  Products

Registry
              Pilot Transaction
                                Pilot
 Portfolio                     Carbon
Shareholder                    Portfolio




           85k Deposit
                                           Carbon
Registry                 Insurance
                                           Rating
           5k Reserve     Products
                                           Engine
Ratifying Kyoto
                                        Economics of Kyoto:
                          Cost Projections with & without the U.S.
                                                                                      Kyoto with U.S.
                    $45
                                                                                      Kyoto without U.S.
                    $40

                    $35
Price ($/ton CO2)




                    $30

                    $25

                    $20

                    $15

                    $10

                    $5

                    $0
                           MIT - EPPA    ABARE - GTEM   CICERO   W. Nordhaus - RICE   Richels & Manne -
                                                                        2001               MERGE
          Examples: State & Local CO2 Programs in US
                                                                                                   NH:   4P legislation requiring 3
                              Seattle,WA: Long-term goal of zero net GHG                            power plants to reduce CO2
                                emissions from Seattle City Light, which has                       emissions to 1990 levels passed
                                purchased reductions from OR Climate Trust                         House of Representatives and is
OR:    CO2 standard for                                                                              being considered by State
   new power plants -                                                                               Senate; sources may purchase
    17% below most                                                             WI: GHG registry   credits from 11 NE states; GHG
  efficient natural gas                                                        being developed         registry being developed
plant; reductions can be
purchased from Oregon
                                                                                                      MA:     Law requiring 10%
    Climate Trust or
    generated from                                                                                     tonnage and rates cuts in
   approved projects                                                                                     CO2 emissions from 6
                                                                                                          existing power plants;
                                                                                                         sources may purchase
    Portland, OR:                                                                                    external CO2 offsets; GHG
   20% below 1988                                                                                       registry being developed
   CO2 emissions by                                                                                 NY:  GHG Task Force
        2010                                                                                             established;
                                                                                                     recommendations for
                                                                                                     federal 4P reductions

  CA: GHG Climate                                                                                   NJ:  Statewide GHG
  Action Registry being                                                                               emissions reduction
       developed                                                                                      target of 3.5% below
                                                                                                      1990 levels by 2005;
                                                                                                     voluntary generation of
                                                                                                        GHG credits and
                                                                                                       banking in NJ credit
               OK:   Oklahoma Carbon Sequestration                                                          registry
                 Enhancement Act - program allows
                 state to certify carbon sequestration
                  from changes in farming practices


                                  TX   developing GHG registry
                                               Ratification scenarios using different combinations of Annex 1 Parties
                                          60
                                                                                                                               Ratified
                                                                                                                        Can
                                                                                                         JAP
                                                                                                                        Aust
                                          50
% 1990 CO2 emissions of Annex 1 Parties




                                                                           Can

                                                   Aust       Can          Aust                                                Not ratified
                                                                                        Rus
                                                                                                         Rus
                                                                                                                        Rus
                                          40
                                                   JAP        JAP          JAP




                                          30                                                                                     Other Europe (OE)

                                                                                                          OE            Acc
                                                                                                                        OE       • Bulgaria
                                                                                                                                 • Czech Republic
                                                                                                                                 • Estonia
                                          20
                                                                                                                                 • Hungary
                                                   US          US           US          US
                                                                                                                                 • Latvia
                                                                                                                                 • Norway
                                                                                                          EU            EU       • Poland
                                          10
                                                                                                                                 • Romania
                                                                                                                                 • Slovakia
                                                                                                                                 • Switzerland

                                                  46.7 %      47.9 %       50.0 %      53.5 %            58.1 %     55.0 %
                    Conclusion
• Proof of Concept Exists & The Cost of Carbon
  is not Zero
• Market developments will be influenced by:
  –   The pace of Ratification of the Kyoto Protocol
  –   The pace of Harmonization of domestic programs
  –   The Launch schedule of the EU trading scheme
  –   Actions and attitudes in Russia
• New US proposals will reinforce international
  support for the Kyoto process
• A liquid carbon market may be 2-3 years away
Contact: Frank Joshua, Managing Director
Natsource Tullett Europe
54-62 New Broad Street
London, UK.
Tel. 44 20 7827 2612
Email: fjoshua@natsource.com
Web site: www.natsource.com

				
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