Buying and selling the right to pollute

Dozens of people in the EU today work on a market that did not even exist three years ago. This new market does not involve busy brokers rushing through a crowded stock exchange. It is more likely to see small office teams phoning between buyers and sellers, at a more leisurely pace.

About ten brokers and 100 traders in Europe buy and sell something that was until recently considered just an invisible, intangible substance in the air.

The EU carbon market, on which companies can buy and sell the right to emit carbon dioxide (CO2), was launched in 2005. Permits for emissions of over 800 megatonnes of CO2 were traded last year.

In a broad sense this emission trading system (ETS) is like any other market, says Andreas Arvanitakis, senior analyst at Point Carbon, Europe’s only dedicated carbon market analysis company. "Carbon behaves like any other commodity: it responds to supply and demand."

But the new market is more closely linked to policies than trade in oil or bonds. "Emissions trading was born of policies and is very closely linked to policies," says Arvanitakis. Announcements from Brussels have therefore been closely followed by changes in trading prices.

Last April, for example the price of a permit for a tonne of carbon fell from €30 to less than €9 when the European Commission announced that countries had massively over-allocated trading permits for the first year of the ETS.

Carbon trading prices this month hit an all time low, with the cost of trading permits falling to less than €4. This brings the selling price close to transaction costs, says Arvanitakis, and is lower than several people thought prices would go. He says the low price suggests that investors feel there are too many carbon permits on offer this year as well.

The low follows a Commission decision to send back 12 national allocation plans (NAPs) and demand heavy cuts for the second round of trading, over the period 2008-12.

Whether or not prices rise again for this second period depends largely on the Commission’s behaviour with the other 15 NAPs, says Arvanitakis. "As well as market fundamentals like coal and gas prices, and the weather," he explains, "market prices ahead will be a direct response to Commission decisions."

Last year’s market crash was more complicated than the latest slump, says Arvanitakis.

"Last year the supply was slow, but the demand was still there," he says.

Market supply was coming mainly from small operators, particularly in eastern Europe, who were only happy to sell when they were sure there was no risk.

Steady demand, on the other hand, was coming from the power utilities sector. "These companies have to buy fuel and the carbon permits to cover emissions from that fuel on a forward basis, to hedge their investments," he says. "And they have to do this on a daily basis."

But this year utilities companies have mostly finished hedging investments for the rest of 2007 and are focusing on planning for the second phase.

Industry has in the past complained that the emission trading periods are too short: three years for the first round and five for the second. The Commission is expected to address the question of trading periods in its ETS review this year.

But Arvanitakis warns that for the market to function properly a balance has to be struck between long-term security and short-term market efficiency. An over-stretched trading period could, he explains, lead to compliance problems. "For example," he suggests, "it could be good for investors to know their emissions allocations up to 2020, but at the same time have to comply with shorter trading periods."

Point Carbon was started up in 2000 by a team of Norwegian academics, when carbon trading was only a possibility. "They saw a business opportunity here before the EU even had an emissions trading directive," says Arvanitakis. "They were confident a market would happen and had faith in carbon behaving like any other commodity."

The busy brokers and traders on Europe’s new market, along with the 100 Point Carbon workers, have proven that the Norwegians were right.

Dozens of people in the EU today work on a market that did not even exist three years ago. This new market does not involve busy brokers rushing through a crowded stock exchange. It is more likely to see small office teams phoning between buyers and sellers, at a more leisurely pace.