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Carbon Derivatives Market in India Executive Summary Energy security, resource conservation, reduction of pollution and protection of natural habitats has got governments all around the world interested in carbon trading. Investor interest in the emerging global carbon credit market has created apt conditions for risk management products, ranging from insurance to derivatives. The carbon trading market allows polluting companies to pay others to cut carbon emissions on their behalf so as to meet the reduction targets set by Kyoto Protocol.
A high volume of trading in the carbon derivatives market helps price discovery and liquidity, and in this way helps to set a clear price signal which helps businesses to plan investments. India has a unique opportunity to become the leader in Carbon trading market. By 2012 emission reduction projects from India are expected to yield around 400 million CERs but it has to guard against the prowess of China to race ahead and capture the market. Main Article
Carbon credit derivatives are contracts which allow the buyer and seller enter into a legally binding agreement to buy or sell carbon credits to be delivered at a future date at a pre-fixed price. Energy security, resource conservation, reduction of pollution and protection of natural habitats are caused governments all around the world interested in carbon trading. Investor interest in the emerging global carbon credit market has created apt conditions for risk management products, ranging from insurance to derivatives.
There is a growing recognition of carbon as a commodity that can be traded in spot market, and in the form of other complex financial products, such as derivatives and exchange-traded funds. Currently the carbon credit trade in Asia is dominated by China and India with carbon emissions trading showing the potential to become the world’s leading derivatives product as companies in Asia and the US seek to lower their greenhouse gas emissions. Carbon Credit A Carbon Credit or Certified Emission Reduction is basically the right to pollute, sold by those less-polluting companies to those cannot curb their carbon dioxide emissions yet.
The unique thing about carbon credits as an asset is that their prices rely more on the laws passed by legislative bodies in respective parliaments than on any financial ratios or interest rates. A carbon credit is generated by reducing a tonne of carbon dioxide. If a group plants trees to reduce emissions by a tonne, it will be awarded a credit that can be sold in the carbon trading market. Therefore, a company which wants to emit more pollutants would need to buy extra credit from this group to be able to do so.
Companies generate carbon credits from emission offset projects which can be used by the international entities to meet their emission reduction commitment under Kyoto Protocol or any regional emission trading scheme such as EU-ETS. Carbon Trading Carbon trading is similar to the exchange of securities and commodities, under which carbon credits are the assets. It is the mechanism of trading between companies, the right related to gas emissions such as carbon dioxide, which are considered the cause of global warming.
It was adopted by the Parties of the United Nations Framework Convention on Climate Change (December 1997), as a scheme to reduce greenhouse gas emissions efficiently using a market mechanism, and was incorporated into the Kyoto Protocol. Kyoto Protocol has separated the governments into two general categories: developed countries, who have accepted greenhouse gas emission reduction obligations and developing countries, who have the responsibility but no obligations of greenhouse gas emission reduction.
The protocol includes mechanisms which allow developed economies to meet their greenhouse gas emission limitation by purchasing GHG emission reductions from elsewhere. These can be bought from financial exchanges, from projects which reduce emissions in developing economies, like China and India, under the Clean Development Mechanism (CDM). CDM Executive Board accredits Certified Emission Reductions (CER) which can be bought and sold in this manner. The carbon trading market allows polluting companies to pay others to cut carbon emissions on their behalf so as to meet the reduction targets set by Kyoto Protocol.
Governments have imposed fixed emissions limits on companies who then offset their excesses by buying allowances in the market. Need for Carbon Derivatives For companies investing in greenhouse gas reduction projects, it is essential to know what the future price of the emissions will be. For example, let a Company X invests in a greenhouse reduction project to reduce 100,000 t of CO2 in 5 years with an investment of $100 million. Now, if after 5 years the average market price is $500 per ton, then the company has made losses on this investment.
Had this company known the future price beforehand, it would have made a rational decision of discontinuing this project and looking for a more favourable investment opportunity. To eliminate this risk of future emissions price fluctuations, company X needs to hedge the risk using derivatives. It can short a futures contract with another market participant in order to receive a pre-determined price at end of five years. Thus the price volatility risk can be eliminated. This market allows emissions reduction project developers, who generate credits under the Clean Development Mechanism (CDM) of the Kyoto Protocol, to hedge against price risk.
So if a firm reduces emissions through a landfill methane gas capture project and enters into a futures contract to deliver the resulting carbon credits, the firm can ensure that there is no loss in credit revenues by purchasing futures contracts. Similarly, the buyer can also hedge his position against rise in carbon credit prices. A high volume of trading in this market helps price discovery and liquidity, and in this way helps to keep down costs and set a clear price signal which helps businesses to plan investments. Advantage India India is the second largest supplier of CERs in the world after China.
Together they control around 82% of the market. The advantage with these two countries is that they have no obligation to reduce emissions under the Kyoto agreement and hence they have the opportunity to invest in GHG reducing projects to earn carbon credits which can further be sold to developed countries that have an obligation to reduce emissions. [pic] Out of the 978 projects that have been registered under Clean Development Mechanism (CDM) of the United Nations Framework Convention on Climate Change (UNFCCC),??332 projects are from India. 43 projects are at various stage of validation or registration. All these projects from India are expected to yield close to 400 million CERs by 2012. The market to buy and sell such credits is surging especially in Europe where most countries have signed the U. N. Kyoto Protocol to curb CO2 emissions. The value of global carbon markets grew by 80 percent from 2006 to 2007, reaching $60 billion in 2007, according to consulting group Point Carbon. In volume terms, 2. billion tonnes of carbon dioxide equivalent credits were traded, up 64% increase over 2006. Carbon trading is estimated to be worth $154. 6 billion in 2008 and $3. 1 trillion by 2020. Opportunities The trade in carbon credits is only going to expand as pressures to sign the Kyoto Protocol increases and more countries start rushing to meet the Kyoto Protocol deadlines which is going to benefit India and China the most. The signs from the world leaders have been encouraging. G8 leaders have set a goal to halve greenhouse gas emissions by 2050.
To help the Asian Carbon Credit markets, the ADB is setting up a $200-million fund, enough to finance about 40 carbon reduction projects, even beyond 2012, the cut-off date for the Kyoto protocol. The move is expected to encourage other public and private investors to invest in carbon credits that may come on stream after 2012. Threats & Challenges ??? Non-existent Local Market: Some analysts fear that India might have started the trade too early as there is almost non-existing local demand for credits which is necessary to sustain the market in long-term.
There is no local demand in the region except from Japan, which remains the major buyer of CERs in Asia to meet its Kyoto obligations. Other Asian countries still do not require companies to reduce emissions. An exchange requires liquidity for which a healthy match of demand and supply is necessary. ??? Chinese Surge: China is getting surging ahead of India as far as trading in carbon credits is concerned. China which accounts for 46% of current clean development mechanism (CDM) projects, against 36% for India is a major competitor.
Given China’s capacity to implement projects on massive scale, it threatens to eat up massive share in this market. According to analysts, by 2012 the CER market in Asia is expected to be dominated by Chinese firms with a 66% share and India with just 19%. ??? Price Volatility: The market for carbon credit is extremely volatile. Prices can quickly move up or down. Current Status in India Carbon Trading Market in India is in a nascent stage. India’s largest commodity exchange, Multi Commodity Exchange of India launched trading in European Climate Exchange (ECX)-based futures contracts in January 2008.
The National Commodity & Derivative Exchange Ltd (NCDEX) subsequently launched trading in Carbon Derivatives in April, 2008. Innovation The market has reached a stage where the insurers and other financial institutions have started to think about diverse products. In December 2007, Credit Suisse in a joint venture with Dublin-based Eco Securities launched collateralised debt obligation (CDO) , a carbon structured product ???that allows investors to choose the level of risk they take on, by tranching the risk that projects will under-perform expectations.
Munich Re and Carbon Re offer policies covering the non-delivery of carbon credits, a pioneering move for the Kyoto carbon credit market. Hong Kong Stock Exchange is planning listing of green Initial Public Offerings (IPOs). It will involve listing companies that provide products and services which help to reduce emissions. As the market grows, more such innovative products are expected to be traded in future.