Joining the dots: Linking carbon markets from the bottom up

Having spent the opening day of Carbon Expo 2012 in Cologne confronting the reality of an increasingly fragmented carbon market, day two saw participants grapple with the possibilities and practicalities of trying to link these bottom-up markets together – whether bilaterally, regionally or plurilaterally in and outside of a possible second commitment period of the Kyoto Protocol.

The bottom-up emergence of national carbon markets outside the historical EU epicentre is now testing the creativity of policymakers and market participants to link up what are in many cases diverging schemes, from California and Australia to  New Zealand, South Korea and Mexico. Not to link up at all is an alternative, which might ultimately be the preference of a number of schemes, particularly China.

The emergence of these various schemes, some of which are slated for near term starts and some of which have just hit the drawing board, has led to the realisation that, despite the economic efficiency advantages, linking will present major political, legal and practical challenges.

For Australia, linking – along with domestic offsetting under the Carbon Farming Initiative – is of course a key premise that underpins the carbon pricing scheme to help deliver targeted emission reductions at least cost, with up to 50 per cent allowed from international units in the near-term.

To make the most of this opportunity, liable entities in Australia will need to be thinking about the near-and longer-term markets that that will ultimately be eligible and scalable enough to meet Australian demand.

Central to eligibility will be the level of trust in the rules and frameworks that underpin these various schemes. Many of the sessions here in Cologne have been considering the real challenges with respect to harmonising approaches to additionality, methodologies, MRV and the specific requirements that different offset projects must meet.

This is particularly evident with respect to those regimes, such as Australia, Californian and New Zealand, that are strong supporters of sequestration-based offsets, compared to the EU ETS which not only has no domestic offset scheme, but is also placing increasing qualitative restrictions on the use of different types of offsets (i.e. CERs). In this sense it is likely that once national schemes are developed, they will look to build regional relationships with like schemes that adopt similar philosophies and offsetting approaches.

While CERs under the CDM are assumed to be the primary means of linking, discussions in Cologne have made it clear that many other opportunities are emerging which Australia might also be able to take advantage of, albeit with many issues still remaining to be resolved:

-- Voluntary markets: the State of the Voluntary Market Report – launched at Expo yesterday – brought welcome good news from the voluntary carbon market. The total value of voluntary markets grew to $US569 million in 2011, hitting 87 million tonnes of CO2, up from 69 million tonnes in 2010. With the growth in the Verified Carbon Standard and scope of projects covered, there might be some advantages for Australian liable entities being able to access VCS credits.

-- REDD : as was the case in Durban, the focus on REDD continues to be expanded to incorporate broader land-use and agriculture.  The growing recognition of the overlap between climate change, land-use and agriculture continues to be a key focus for policymakers. Linking of REDD to national schemes will help to build investor interest in REDD , although it is becoming increasingly clear that the absence of any real market demand for REDD credits continues to remain an obstacle to significant private sector investment.

Day two also saw discussion on the increasingly important role of financial innovation and how to ensure that public finance could be effectively deployed to ensure private sector engagement. There is broad recognition that due to the policy uncertainty, coupled with the high-risk, low-rate of return now characteristic of carbon market investments, some alternative initiatives need to be pursued.  This is most likely to require a range of financial instruments that ultimately de-risk investments in the carbon market.  Simple ad-hoc reform of existing market mechanisms like the CDM probably won't be sufficient to engage the private sector.

On the margins, there was continuing discussion about the likelihood of the EU pursuing a set-aside policy under the EU ETS. Overall, there seems to be optimism the EU will pull a large quantity of EAUs out of the market, although the exact quantity remains uncertain. 

Clearly the greater the number of EUAs set aside, the greater the impact this will have on the EUA price. Earlier reports this week talked about prices heading back towards €20, while others think that regardless of what happens with the set-aside, the real impact will not be known until after 2013. And of course the global carbon price is highly relevant for Australia with our comparatively high level of linking.

Many market participants here in Cologne recognise that continued uncertainty has heavily affected the level of demand for all forms of carbon credits – whether they are CERs or VCUs. This lack of demand, coupled with oversupply, remains a significant barrier to new transactions taking place.  Furthermore, the significant fall of the CER price has seen many CER buyers attempt to renegotiate contracts. 

While in some cases buyers are looking for legitimate grounds on which to terminate contracts, it is also clear there are a range of market players who might simply be refusing to honour their obligations. Whether or not this will lead to a wave of contract disputes remains to be seen.

In the meantime, project developers and market participants are trying the best they can to understand the future policy frameworks and piece them together in order to maximise opportunities for trade – both within and between the various schemes now emerging.

Paul Curnow, Partner, Baker & McKenzie.