Arbitrage opportunities between EU Emission
Allowances and Certified Emission Reductions
THE FUNCTIONING OF THE LINKING DIRECTIVESupervisor Catrinus J. Jepma
Author Alvar B. de Wolff
Student number 1157167
University University of Groningen Faculty Faculty of Economics E-mail alvardewolff@gmail.com Telephone +316 129 37 753
Abstract
The fundamentals of modern finance are to a great extend build upon the logic of arbitrage. If homogeneous groups of assets with different capital structures are priced differently, investors should engage in arbitrage until any deviation in the prices are eliminated. In this research study the insight of arbitrage is applied to the market for the European market carbon credits. In January 2005 the largest community-wide greenhouse gas emission trading scheme (EU ETS) started within the European Union. With such a cap-and-trade system the right to emit greenhouse gases becomes a tradable commodity. EU ETS participants are allowed to buy and sell emission allowances on the EU ETS market. In 2004 the EU adopted the Linking Directive, which creates the conditions to use credits generated by emission reduction projects certified by the Kyoto Protocol within the EU ETS. Since the Linking Directive is adopted emission credits and emission allowances are considered to be fully fungible for compliance within the EU ETS. This could imply that emission credits (CERs) and emission allowances (EUAs) are identical or essentially similar goods. Until now CERs are continuously priced at a discount compared to EUAs. From economic theory one could expect arbitrage opportunities and possible price convergence between CERs and EUAs to occur in the carbon market. The research concludes that only in specific situations CERs and EUAs can be considered to be essentially similar goods. The EUA is a definite property right, but a CER is a more uncertain commodity. The CDM market complex and an investor must incur high risks and transaction costs. The cap on the use of CERs for compliance in the EU ETS is the most important restriction on the convergence of CER and EUA prices.
Acknowledgements
During the final stages of my study business economics my interest focused more and more on energy related issues. After the organization of the first Energy Convention Groningen I decided that my master thesis should deal with an energy related topic. Emission trading and the global carbon market struck me the most. It is a new, dynamic and to some extend undiscovered field of research and I think it will become even more important in the new future. The combination of financial theory and greenhouse gas emission trading resulted in a challenging and interesting research study.
This research is a qualitative and exploratory study. I had the ability to interview professionals active in the carbon markets and experts in EU emission trading. I gained a lot of interesting insights and the interviews resulted in a thorough understanding of emission trading. I would like to thank all interviewees for their valuable time, and their ability to share their knowledge.
I would like to express my gratitude to professor Jepma. As an authority in the field of climate policies and emission trading I could not have wished for a better supervisor. I want to thank professor Jepma for inspiring me. I like to thank dr. Wiersma for his flexibility and comments, and Wytze van der Gaast (Foundation JIN) for his guidance and great expertise. I thank Age van der Mei for his help, invaluable comments, and humor during our time of research. Finally, I thank my parents and my brother for their moral support.
Abbreviations
AAUs - Assigned Amount Units
CDM - Clean Development Mechanism
CDM EB - Clean Development Mechanism Executive Board
CERs - Certified Emission Reductions
CITL - Community Independent Transaction Log
CO2e - Carbon Dioxide equivalent
COP - Conference of Parties
DNA - Designated National Authority
DOE - Designated Operational Entity
EB - Executive Board of Clean Development Mechanism
ER - Voluntary Emission Reduction
ERPA - Emission Reduction Purchase Agreement
ERUs - Emission Reduction Units
ET - Emission Trading
EU ETS - European Union Emission Trading Scheme
EUAs - European Union Allowances
GHGs - Greenhouse Gases
GWP - Global Warming Potential
IPCC - Intergovernmental Panel on Climate Change
JI - Joint Implementation Mechanism
JSE - Johannesburg Stock Exchange
ITL - International Transactions Log
LoI - Letter of Intend
Mt - Mega tons
MWh - Megawatt-Hours
NAPs - National Allocation Plans
NGO - Non-Governmental Organization
OTC - Over the Counter
PDD - Project Design Document
PIN - Project Idea Note
UNEP - United Nations Environmental Protection Program
UNFCCC - United Nations Framework Convention on Climate Change
Table of Content
ABSTRACT ... 2 ACKNOWLEDGEMENTS ... 3 ABBREVIATIONS... 4 TABLE OF CONTENT ... 5 1 INTRODUCTION... 72 EU EMISSION TRADING; THE ROLE OF THE ‘LINKING DIRECTIVE’... 10
2.1 CLEAN DEVELOPMENT MECHANISM... 10
2.1.1 Project eligibility ... 11
2.1.2 The CDM project cycle ... 13
2.1.3 CDM market analysis... 16
2.2 EUROPEAN UNION EMISSION TRADING SCHEME... 19
2.2.1 National Allocation Plan (NAP) ... 20
2.2.2 EU ETS market analysis ... 21
2.3 THE ‘LINKING DIRECTIVE’ ... 22
2.3.1 Fungibility... 23
2.3.2 Obtaining CERs/Structure of CDM investments ... 24
3 THEORY OF FINANCIAL MARKETS ... 26
3.1 ARBITRAGE PRICING THEORY... 26
3.2 EFFICIENT MARKET HYPOTHESIS (EMH) ... 28
3.3 LIMITATIONS OF ARBITRAGE... 29
4 DRIVERS OF ARBITRAGE BETWEEN EUAS AND CERS ... 31
4.1 NON TRANSPARENCY OF THE CDM MARKET... 31
4.2 INTERNATIONAL TRANSACTION LOG... 32
4.3 RISK PERCEPTIONS... 34
4.4 REPUTATIONAL DIFFERENCES... 35
4.5 CAP ON USE OF CERS FOR COMPLIANCE... 37
5 METHODOLOGY ... 38
5.1 RESEARCH METHODS... 39
5.2 VALIDITY... 41
5.3 LIMITATIONS... 41
6 PERCEPTIONS OF DUTCH INSTALLATIONS IN THE EU ETS... 43
7 ARBITRAGE BETWEEN EUAS AND CERS ... 48
7.1 EUAS AND CERS; IDENTICAL GOODS?... 48
7.1.2 Obtaining CERs ... 55
7.1.3 Rating of CDM credits ... 56
7.1.4 Reputational differences ... 56
7.2 RISK AND UNCERTAINTY... 59
7.2.1 Risk perceptions ... 59
7.2.2 International Transactions Log... 61
7.2.3 Investment uncertainty post 2012... 62
7.2.4 Cap on use of CERs ... 64
7.3 FUTURE FUNCTIONING ‘LINKING DIRECTIVE’... 65
8 DISCUSSION ... 68
8.1 NAP2 ALLOCATION CARRYOVER... 68
8.2 ALTERNATIVES FOR ALLOCATION... 70
9 CONCLUSION ... 71
REFERENCES ... 73
APPENDIX 1: TOOL FOR DEMONSTRATION OF ADDITIONALITY... 79
APPENDIX 2: QUESTIONS SEMI-STRUCTURED IN-DEPTH INTERVIEWS... 80
1
Introduction
Climate change is one of the greatest challenges facing our planet in the coming decades and centuries. It impacts on the environment, human health, our livelihoods, social relationships and the global economy. The emissions of carbon dioxide and other greenhouse gases are related to global warming. During the last decade global warming became an important political issue and governments started to take measures to curb greenhouse gas emissions. The international community strives for sustainable development and a substantial reduction of greenhouse gas emissions in order to be able to meet this critical challenge.
As a result of the global attention for climate change the Intergovernmental Panel on Climate Change (IPCC) issued in 1990 a First Assessment Report. This report reflects the views of 400 scientists on the threats posed by global warming. The report (IPPCC, 1990) stated that global warming was a real problem which is caused by humans. The IPCC urged that the international community should take measures to curb greenhouse gas emissions. The United Nations Conference for Environment and Development in 1992 resulted in the establishment of the United Nations Framework Convention on Climate Change (UNFCCC). The UNFCCC sets an overall framework for intergovernmental efforts to tackle the challenge posed by climate change. At the first conference of the UNFCCC the negotiations for a Protocol with binding targets started. The resulting Kyoto Protocol is ratified by 141 countries, including all major industrialized countries, except for the United States and Australia.1
The Kyoto Protocol commits Annex 1 countries (i.e. 39 industrialized countries) to individual, legally binding targets to limit or reduce their greenhouse gas emissions.2 As part of the
quantified emission limitations every country has been assigned an amount of Assigned Amount Units (AAUs), which are calculated in tons of CO2 equivalent (CO2e). The first commitment period of the Kyoto Protocol starts in 2008 and ends in 2012.
Developing countries are not part of these legally binding targets. The reason behind this exclusion is that it was considered that the climate change problems at the moment have been caused by the industrialization of developed countries in the last decades. The individual reduction targets for Annex 1 countries add up to a total cut in greenhouse gas emissions of 5.2% from 1990 levels in the commitment period of 2008-2012.
1 The Kyoto Protocol would enter into force only when the number of UNFCCC Parties that ratified it
accounted for 55% of all GHG emissions. In November 2004 Russia ratified; the threshold was achieved.
2 The Kyoto Protocol covers six main greenhouse gases: Carbon dioxide (CO2), Methane (CH4), Nitrous
Three flexible mechanisms make up the Kyoto Protocol. The mechanisms are established in order to give the Annex 1 countries more flexibility to reduce emissions. The Kyoto Protocol demands that the use of the mechanisms is supplemental to domestic action and that domestic action should constitute a significant element of the effort made by each Party included in Annex 1 to meet its quantified emission limitation and reduction.
The three flexible mechanisms of the Kyoto Protocol are:
Joint Implementation (JI); as defined in Article 6 of the Kyoto Protocol. The Annex 1
Parties can contribute to their emission targets by investing in emission reduction projects in other Annex-1 countries. These investments eventually result in Emission Reduction Units (ERUs) which can be used for compliance in the Kyoto Protocol.
Clean Development Mechanism (CDM); as defined in Article 12 of the Kyoto Protocol.
Annex 1 Parties can undertake emission reduction projects in developing countries (non-Annex 1), which lead to Certified Emission Reduction (CER) credits. These credits can be used for compliance in the industrialized countries.
Emission Trading; as defined in Article 17 of the Kyoto Protocol. Annex 1 Parties can
acquire emission credits Assigned Amount Units (AAUs) from other Annex 1 Parties and use them for compliance under the Kyoto Protocol.
A provision negotiated in the Kyoto Protocol is the so-called EU Bubble. It allows EU Member states to meet the commitments jointly by combining emission reductions across the EU. The overall commitment of the EU is a reduction of 8% from 1990 levels, but after the burden sharing under the EU bubble Portugal is allowed to emit 27% more and Luxemburg has to reduce emission by 28% from the base year.3 In January 2005 the European Union Emission Trading
Scheme (EU ETS) commenced operation as the largest multi-country, multi-sector Greenhouse Gas emission trading scheme world-wide.4 The EU ETS is one of the key policies of the
European Union introduced in order to meet the greenhouse gas emission reduction targets agreed upon in the Kyoto Protocol.
The emission trading is based on a ‘cap-and-trade’ system. The system puts a cap on the total emissions of greenhouse gases and allows participants to trade emission allowances with each other. A participant can decide whether to trade, use, or bank its emission allowances, depending on its emission trading strategy. A market mechanism of emission trading is to encourage
3 The agreement in which the EU Member States’ individual emission reduction targets are explained is the
so called EU Burden Sharing Agreement for the Kyoto Protocol.
emission reductions to be made where they are most economic. In industrialized countries it is generally more expensive to mitigate emissions, whereas developing countries have extensive opportunities to reduce emissions less expensive. However, industrialized countries are obligated to realize a considerable amount of emission reductions domestically.
At this moment the two main pillars of the global greenhouse gas market are the EU Emission Trading Scheme (EU ETS) and the Clean Development Mechanism (Marcu, 2006). This research aims to explore the linkange between the two pillars. In 2003 the European Parliament established a Linking Directive which links the EU ETS with the flexible mechanisms from the Kyoto Protocol. The aim of the Linking Directive is to give installations within the EU ETS the possibility to meet their emission reduction targets against lower costs. The perceptions of installations about the Linking Directive an the use emission reduction credits for compliance in the EU ETS is an important issue in this research. While some opponents of the Clean Development Mechanism criticize it as a way for rich countries to pass on their obligation and not cut emission at home, supporters argue that because greenhouse gases affect climate globally, a reduction in the developing countries helps to combat climate change in equal measure to a reduction in Europe (Karr, 2006).
The economic concept of arbitrage is the fundament for the analysis of the different carbon markets. Both emission allowances and emission credits can be used to meet emission targets of entities within the EU. However, the prices of the allowances and credits differ substantially. Is there arbitrage between emission reduction credits from the CDM and EU emission allowances in the period 2008-2012?
2
EU Emission trading; the role of the ‘Linking Directive’
The Kyoto Protocol set a target reduction for 15 EU member states of 8% from 1990 levels. The 8% constitutes the ‘EU Bubble’ and within the bubble the EU member states reached an agreement to share the burden of reducing GHG emissions. In order to meet its Kyoto targets the EU has established its own emission trading scheme (EU ETS) in which large emitting industries participate. This scheme is linked with the flexible mechanisms of the Kyoto Protocol i.e. joint implementation and the clean development mechanism. As discussed in the introduction this research is focused on the link between the EU ETS and the Clean Development Mechanism. The interaction with Joint Implementation is beyond the scope of this research. In order to provide an understanding of the link between the Clean Development Mechanism and the EU ETS this chapter consists of a literature study on both elements. Section 2.1 starts with an introduction on the Clean Development Mechanism. Section 2.2 further explains the EU ETS. In section 2.3 the link between both elements is discussed.2.1 Clean Development Mechanism
The Clean Development Mechanism (CDM) allows Annex 1 countries to acquire certified emission reductions (CERs) by undertaking greenhouse gas (GHG) emission reduction projects in non-Annex 1 countries. The purpose of the CDM, as defined in the Kyoto Protocol Article 12, is that it shall assist Parties not included in Annex 1 in achieving sustainable development. The CDM makes a contribution to the ultimate objective of the Convention, and to assist Parties included in Annex 1 in achieving compliance with their quantified emission limitation and reduction commitments. In this sense the CDM provides mutual benefits for investors from developed countries and for developing countries, who host CDM projects. Developing countries can voluntarily participate in CDM projects in order to mitigate greenhouse gas emissions. The flexible mechanisms reduce the costs for Annex 1 countries of attaining their emission reduction commitments. This is due to the fact that Annex 1 countries have the flexibility to undertake emission reductions projects where they can. This flexibility consists of the developing country, the sectors and the gases in which mitigation takes place (Ellis, 2004).
Section 2.1.1 and 2.1.2 explain the traits of the Clean Development Mechanism. Specific issues covered are the project eligibility and the project cycle. After the guidelines and procedures of the CDM are discussed, section 2.1.3 tries to shed light on the market developments in the CDM market.
2.1.1 Project eligibility
The Clean Development Mechanism has two main objectives. The first objective is to contribute to sustainable development in developing countries. Other benefits for developing countries may be a transfer of clean technology, foreign direct investment, and an income stream from the sale of generated CERs. The second objective is to realize reductions of greenhouse gas emissions in developing countries in order to help Annex 1 countries to meet their emission targets in a cost efficient way. The criteria of project eligibility are introduced to guarantee that a CDM project meets the objectives of sustainable development and actual reduction of emissions. The CDM is designed to create a win-win situation for both developing and Annex 1 countries. If CDM projects are indeed designed according to both goals, the synergy effects arise (Burian, 2006). According to Kyoto Protocol Article 12, §5, CDM projects shall be certified on the basis of: (a) Voluntary participation approved by each Party involved; (b) Real, measurable, and long-term benefits related to the mitigation of climate change, and (c) Reductions in emissions that are additional to any that would occur in the absence of the certified project activity.
One of the main concerns of environmental NGOs is the question if real emission reductions take place within a CDM project. To ensure the environmental integrity of the CDM projects, the concepts of additionality and baselines were adopted. These concepts are very important, because if ‘false’ CDM projects are certified and used by Annex 1 countries this will result in a global increase of greenhouse gas emissions. In such a situation the CDM realizes no actual emission reductions, but the Annex 1 countries would use the credits for their emission reduction target. To prevent these, so called, ‘business as usual’ projects to be certified under the CDM, the project participants are obligated to convince the Executive Board of the integrity of their CDM project. At first sight this reasoning seems clear, but there has been ongoing debate in the CDM field about the interpretation of the concept of additionality.
A CDM project is additional – according to the Marrakesh Accords §43 – if anthropogenic emissions of greenhouse gases by sources are reduced below those that would have occurred in the absence of the registered CDM project activity. In practice the assessed additionality has proved to be difficult and contestable. Different stakeholders of a CDM project come to opposite conclusions when it gets to the additionality criteria of a particular project (CDM Watch, 2003). The main reason lies in its counterfactual nature. In the case of a CDM project being implemented, it will never be possible to find a definite answer to the question what would have happened without this project. The answer remains – even ex-post – a highly hypothetical one (Sutter, 2003: p.57).
Sutter (2003) makes a distinction between on the one side only environmental additionality, and on the other side environmental additionality plus project additionality. Environmental additionality is that a carbon emission reduction project should result in greenhouse gas mitigation compared with a ‘business as usual scenario’, i.e. the hypothetical baseline. Project additionality contains factors without which the concerned carbon emission reduction project would not have happened (Asuka, 2004 and Sutter, 2003).
Within this definition of project additionality three other additionality concepts can be distinguished:
Investment additionality; is that the project developer would not have invested in the project without the CDM, because the project is not commercially viable without the revenue stream generated by the CERs (Langrock, Michaelowa and Greiner, 2003; Asuka, 2004).
Financial additionality; is that the concerned carbon emission reduction project should not be diverted from Overseas Development Assistance. Official development aid from developed countries should not be used to finance CDM projects (Asuka, 2004).
Technical additionality; is that the technologies employed in the project should be the best available technology for the CDM host country, in order to provide for an optimal technology transfer.
The different additionalities discussed above each increase the burden of proof for the project participants. From an environmental perspective these additionalities seem to be favorable, however they would reduce the attractiveness of CDM investments considerably.
To make the concept of additionality more explicit the CDM EB released the “Tool for the demonstration and assessment of additionality” (UNFCCC, 2004). The tool consists of 5 steps:
1) identification of an alternative 2) investment analysis
3) barrier analysis 4) common practice
5) impact of CDM registration
With this tool the EB makes a case for requiring project additionality. The investment additionality and financial additionality are necessitated by the EB, but the technological additionality is not required. The schematic outline of the “Tool for the demonstration and assessment of additionality” is attached in Appendix 1.
To determine the number of credits that could be generated by an individual CDM project, an indication is needed of what GHG emissions would have been in the absence of that project (i.e. what would have happened otherwise). The amount of GHG emitted in the hypothetical non-project scenario is referred to as a non-project’s baseline. A baseline is thus a quantification of this hypothetical emission level and may be used for comparative purposes to test for the GHG “additionality” of an individual project (UNEP, 2004). The baseline should be established in a transparent and conservative manner.5
2.1.2 The CDM project cycle
In order to generate CERs with a CDM project the participants must channel the project through a series of institutions. The so called ‘CDM project cycle’ and all its sequential phases are defined in the Marrakech Accords. This section first discusses the main institutions which CDM participants encounter in the project cycle; second the different phases in the project cycle are explained.
In the CDM project cycle there are three important institutions which all apply the modalities and procedures for CDM project in order to assure the eligibility of the project. These CDM institutions are 1) the CDM Executive Board, 2) the Designated National Authorities, and 3) the Designated Operational Entities.
1) The most important institution in the CDM project cycle is the CDM Executive Board (EB). The ten permanent members of the EB are elected by the UNFCCC Conference of Parties. The EB has to check whether projects conform to the rules and it has to formally register the CDM project. The rules and criteria for the project mainly apply to the methodologies used for additionality, baseline, and monitoring plans. During the review and approval of these methodologies the EB is advised by the Methodology Panel.
2) The second institution in the project cycle is the so called Designated Operational Entity (DOE). This DOE is accredited by the EB as an independent third party in the CDM implementation process. The DOE is responsible for the validation of the project in the early stage of the cycle. When the project is implemented the DOE needs to verify and certify the emission reductions generated by the project.
5 Regarding the choice of approaches, assumptions, methodologies, parameters, data sources, key factors
3) The third institution is the Designated National Authority (DNA). These DNAs are located in both the host countries and in the Annex 1 countries. The DNAs assess if the CDM project meets the criteria of sustainable development set by the host country.
Figure 1: Outline of the CDM Project Cycle.
(Source: Ellis et al. 2004)
The different steps in the CDM project are the project design phase, validation and registration phase, monitoring phase, verification and certification phase, and issuance of CERs:
Project design phase – The first step in the project cycle is the identification and formulation of a potential CDM project. The project developer informs the host country of its intentions by sending a Project Idea Note (PIN) to the Designated National Authority (DNA) of that country. The PIN gives indicative information on the type and size of the project, its location, and the anticipated amount of emission reductions. When the Designated National Authority (DNA) approves the PIN the project developer is required to sign a Letter of Intend (LoI). In this letter the parties involved in the CDM project agree upon the conditions for the cooperation and the intention of selling and buying CERs. The various steps from getting the PIN approved until the delivery of CERs to the Annex 1 Party are contracted in an Emission Reduction Purchase Agreement (ERPA).
After the validation of the PIN, the project developer needs to submit a Project Development Document (PDD). This PDD consists of a project description, a baseline methodology, a monitoring methodology, crediting period, and stakeholder comments. The methodologies must be devised according to an approved methodology.6 New methodologies must be authorized and registered by the CDM Executive Board. The Designated Operational Entity ensures that the PDD is in compliance with the guidelines and rules set by the Executive Board.
Validation and Registration phase – The project developer should submit the PDD to a Designated Operational Entity (DOE) which is designated and accredited by the Executive Board. The validation process conforms that all information and concepts used in the PDD are correct. After public comment, the operational entity decides whether or not the CDM project should be validated.7 The Designated Operational Entity (DOE) also requests registration of the proposed
CDM project by the Executive Board. The registration shall be deemed final eight weeks after the date of receipt by the executive board of the request for registration.8
Monitoring phase – At this stage of the CDM project cycle the project has been implemented by the project developer. During the step of monitoring the project developer must implement the monitoring plan contained in the registered PDD which was submitted during the project design phase.9 In the monitoring phase the actual greenhouse gas emissions of the project are monitored. Verification and certification phase – Verification is the independent ex-post determination by a DOE of the monitored emission reductions realized by the project. The DOE must make sure that the CERs have resulted according to the guidelines and conditions agreed upon in the initial validation of the project.10 This means the DOE checks if the project is implemented in the
correct way according to the demands of the EB. After the verification of the CERs the DOE will request the EB to issue the CERs. Certification is the written assurance that a project achieved the reductions as verified.
6 Approved baseline and monitoring methodologies can be found at;
http://cdm.unfccc.int/methodologies/PAmethodologies/approved.html
7 According to the UNFCCC; validation is the process of independent evaluation of a project activity by a
designated operational entity against the requirements of the CDM as set out in decision 17/CP7, the present annex and relevant decisions of the COP/MOP, on the basis of the project design document, as outlined in Appendix B (http://cdm.unfcc.int/projects/pac/howto/cdmprojectactivity)
8 Exceptions to the time schedule of eight weeks are explained in Annex decision 17/CP7 §41. 9 Explained in Annex Decision 17/CP7 §56.
Issuance of CERs – The certification report shall constitute a request for issuance to the EB of CERs equal to the verified amount of reductions of anthropogenic emissions by sources of greenhouse gas. The issuance shall be considered final 15 days after the date of receipt of the request of issuance, unless a Party involved in the project activity or at least three members of the EB request a review of the proposed issuance of CERs.11
2.1.3 CDM market analysis
As the first commitment period of the Kyoto Protocol (2008-2012) is approaching the CDM market is gaining momentum. By 9 August 2006, almost 1000 proposed CDM projects are reported in the pipeline (UNEP, 2006).12 These projects are at different stages of the CDM project
cycle. According to the analysis of the UNEP Risø Centre 649 projects are at the validation stage, which means that the Designated Operational Entity (DOE) is validating the CDM project proposal. These projects expect to generate almost 1.13 billion credits up to 2012. The number of issued CERs has grown to almost 11,000 CERs.
Prices of credits from CDM projects have increased in 2005 and the first quarter of 2006. The prices of CDM credits vary considerable depending on type and contract terms of the project. In a Natsource (2006) report, two sorts of CDM credits are distinguished. The first is a Verified Emission Reduction (VER), which is a candidate CER from CDM projects that have not been registered by the EB. The second is a Certified Emission Reduction (CER), this is a candidate CER from a CDM project that has been registered by the EB.
In 2005, the (volume weighted) average price paid for a VER was $4.43, up 12% from $3.95 in 2004. In the first quarter of 2006, the average VER price was $5.65, up 14% from the 2005 average price. The average price for a CER in 2005 was $7.04, up 37% from $5.15 in 2004. In the first quarter of 2006, the average CER price jumped to $11.56, up 64% from the 2005 average price (Natsource, 2006).
In addition to the direct project market, with Emission Reduction Purchasing Agreement (ERPA) contracts, there is a considerable secondary market, where contracts for future delivery of CERs, not necessary with a specific project attached, are entered into (Point Carbon, 2006: p. 24). This is primarily a company-to-company market, with a majority of transactions which are over the counter. Point Carbon estimates the secondary CDM market to have totaled 4 million CERs or €50 million in 2005. The Natsource (2006) report states that prices in the secondary market for CERs have risen even more sharply from 2004 until now. The average price of CERs
11 See UNFCCC Annex Decision 17/CP7 § 64 and 65
Table 1: Global Warming Potentials Global Warming Potentials
CO2 1
Methane (CH4) 21
Nitrious oxide (N2O) 310
HFC-23 11700
Source:Climate Change (1995)
in 2005 was $22.21, compared to a 2004 average price of $5.82. During the first months of 2006, the average price was $23.33. These prices give a good reflection of the distribution of risks between the seller and the buyer of the CERs. The buyer risks are the highest for the VERs, because the project is not even registered by the EB. The CERs traded in the secondary market are less risky. This is one of the explanations for the high average price of €23.33 for CERs on the secondary market during the first quarter of 2006.
The proposed CDM projects are aiming to mitigate different greenhouse gases in different sectors. Projects take place in sectors like industry, energy, agriculture, waste, transport, and forestry. According to Ellis (2006) the majority of the GHG emission reduction credits come from extremely large projects in the non-electricity sector. In this category the largest emission reductions are achieved by F-gases, N2O and landfill gas recovery (LFG) projects.
As shown in figure 2, the reductions of N2O and F-gases account for 41% of total expected emission reduction credits to be generated to 2012 by CDM projects. The greenhouse gases N2O and F-gases (predominantly HFC-23) are waste gases of industry and have a high Global Warming Potential (GWP) as shown in table 1.
13
There are only a few of these projects, but they generate large volumes of credits and the abatement costs are very low. HFC projects, for
example, generate reductions at a cost of around $0.75 - $1.00 per ton CO2e. These projects are considered to be the extreme ‘low hanging fruit’ of greenhouse gas mitigation and require a very short lead time to implement (World Bank, 2006). The estimated annual GHG emission reductions from the 17 F-gas projects currently in the CDM pipeline are more than the emission reductions from 466 renewable electricity projects (Ellis, 2006). The HFC-23 greenhouse gas has a global warming potential 11.800, which means that a reduction of 1 ton of HFC-23 has the same climate effect as 11.700 CO2 emission reductions.
13 The time horizon of the Global Warming Potential in table 1 is 100 years. The extensive table is
Figure 2: Percentage of annual credits Figure 3: Growth of expected CDM by project type, April 2006 credits by region
Source: Ellis, 2006 Source: JIQ, 2006-2
The geographical distribution of the CDM projects across different host countries is highly concentrated. The number of different host countries has grown to 71 countries, but the majority of expected credits generated by CDM projects are from only three countries. As can be seen in figure 3, 59% of the credits are generated in China (30%), India (18%), and Brazil (11%). The share of Chinese projects in the CDM pipeline has grown very rapidly, mainly due to the seven HFC-23 projects which were proposed during 2005 (JIQ, 2006-2).
The window of opportunity to initiate CDM projects is beginning to close if market uncertainty regarding post-2012 commitments persists. It takes time for a CDM project before it is channeled through the project cycle and is starting to generate CERs. Now the threshold comes closer CDM projects need to have a high return in the coming years until 2012, for the project to be commercially viable. Buyers appear to have a preference for bigger projects, with proportionally lower transactions costs. It is likely that demand will focus on proven technologies with short lead-time projects (World Bank, 2006 p. 30). However, with rising CER and EUA prices it can be projects will be longer commercially viable when the threshold of 2012 nears.
2.2 European Union Emission Trading Scheme
In January 2005 the European Union Greenhouse Gas Emission Trading Scheme (EU ETS) commenced operation as the largest multi-country, multi-sector Greenhouse Gas emission trading scheme world-wide.14 The EU ETS is one of the key policies of the European Union introduced
in order to meet the greenhouse gas emission reduction targets agreed upon in the Kyoto Protocol. The overall commitment of the EU according to the Kyoto Protocol is a reduction of 8% from 1990 levels.
The EU ETS is a market mechanism which is best described as a ‘cap-and-trade’ system. This means an overall limit, ‘cap’, is placed on the number of emission allowances that are issued to participants. The right to emit GHGs becomes a tradable commodity, because the participant is allowed to buy and sell emission allowances on the EU ETS market. One EU emission allowance (EUA) gives a participant the right to emit one ton of CO2-equivalent. The participants of the EU ETS are more than 12,000 installations in the 25 Member States, accounting for around 45% of the EU’s total CO2 emissions.
The EU ETS consists of two phases: the period 2005-2007 is an introduction phase and second phase from 2008-2012, which coincides with the first commitment period of the Kyoto Protocol. In the initial phase the scope of the EU ETS is limited. The Scheme covers in the first phase from 2005-2007 only CO2 emissions from large emitters (installations >20MW) in six major industries. These industrial sectors include: utility combustion plants, oil refineries, coke ovens iron and steel plants, energy-intensive industry, such as cement, glass, lime, brick and ceramics production facilities, and the pulp and paper industries.
The concept of emission trading is based on the assumption that a ‘cap-and-trade’ system, which creates a price for CO2, will offer the most cost effective way to reduce emissions of greenhouse gases. The abatement of emissions is expected to take place at the installations which can reduce emissions against the lowest costs. If an installation is able to abate emissions against low costs, it can sell its surplus of EUAs on the EU ETS market. Installations which possibly exceed their cap of emissions will have a choice to invest resources in reducing emissions or buying extra allowances on the EU ETS market. Under the assumption of profit-maximization of the installations, they will choose the strategy with the lowest costs.
Each year the installations need to ensure the European Commission that they are in compliance with their emission targets. During the first phase non-compliance implies a fine of €40 for each ton of CO2 that has been emitted, but not covered by EUAs. The fine rises to €100 during the second phase of the EU ETS.
2.2.1 National Allocation Plan (NAP)
The EU Member States developed a National Allocation Plan (NAP) which sets out how the EUAs will be issues to the installations within the EU ETS. The NAPs of the EU Member States need to be approved by the European Commission. The total number of allocated emission allowances within an EU Member State must be consistent with the individual emission target of this Member States under the EU burden sharing agreement for the Kyoto Protocol. In table 1 the total number of emission allowances for the EU Member States are stated for the first and the second phase of the EU ETS.
Table 1: National Allocation Plans of EU Member States
Source: Climate Task Force – Caisse des Depôts, 2006
To justify the emissions limits of the NAPs, Member States need to provide details on all sectors that contribute to national emissions. Analysis of reduction cost on a sectoral basis across the EU clearly identify energy and manufacturing sectors as the key areas in which the cheapest reductions could be made.15 One of the reasons for the relatively low abatement costs of the
energy sector is their ability to switch fuels in their power installations.
Over the period 2005-2007 the total emissions are capped at 6,600 Mt CO2 for the sectors within the EU ETS. The power and heat sector received almost 55% of all EUAs, minerals (cement,
15http://europa.eu.int/comm/environment/enveco/climate_change/sectoral_objectives.htm
European Union: National Allocation Plan (NAP), National Registries and CO2 Allowances
NAP1 (2005-2007) NAP2 (2008 - 2012)
No. of 2005 EUAs National share No. of 2005 EUAs Annual allocation trend Step in the process Allocated in
MtCO2 of EUAs allocated in MtCO2 Phase 1 - Phase 2 (July 4 2006) (incl. reserves) Allocated in Europe (incl. reserves)
Germany 495.0 23.2% 482.0 -3.4% Submitted June 30
Poland 239.1 11.1% 279.6 16.9% Submitted July 4
UK 221.5 10.3% 238.0 7.4% Consultation finished
France 155.9 7.3% 149.7 -4.0% Consultation underway Netherlands 89.0 4.1% 109.2 22.7% Consultation finished
Greece 74.4 3.5% 75.7 1.7% Consultation underway
Belgium 62.9 2.8% 37.9 -39.7% Consultation underway Finland 45.5 2.1% 39.6 -13.0% Consultation underway Portugal 38.2 1.8% 33.9 -11.3% Consultation underway Ireland 22.3 1.0% 23.0 3.1% Consultation finished
Estonia 18.9 0.9% 24.5 29.6% Submitted June 30
Lithuania 12.3 0.6% 11.9 -2.9% Consultation underway
Latvia 4.6 0.2% 6.8 47.8% Submitted July 4
Bulgaria 49.7 Enter in 2007 56.1 12.9% Consultation underway
-glass, and ceramics), metals (steel production facilities) roughly 12% each, oil and gas industries roughly 10% (World Bank, 2006).
According to the current available installations list, there are 92 large installations with an allocation of more than 10Mt CO2e in the 3 years period of 2005-2007. Together these accounts for only 0,9% of the total number of installations, but their total number of allowances count up to 34% of the total allocated allowances (Point Carbon, 2006). At the other end the same report of Point Carbon also states that there are almost 9,000 small installations emitting less than 1 Mt CO2e, totaling only 19% of the allowances but more than 90% of all installations. The medium sized emitters, between 1 and 10 Mt, account for 47% of the allowances.
2.2.2 EU ETS market analysis
The EU ETS started on 1 January 2005, but in 2003 and 2004 forward contract transactions already took place and accounted for a volume of almost 1 million tones CO2 in 2003 and 17 million tones CO2 in 2004. After the start of the EU ETS the market for EUAs has grown spectacularly with 362 million tones traded in 2005. These volumes are traded both through brokers and exchanges, and through an unreported bilateral market. According to Point Carbon (2006) the majority, 262 Mt, was traded through brokers and exchanges. The bilateral market for EUAs in 2005 is estimated to be 100 Mt. In the bilateral market there are only direct company-to-company transactions. The non-transparency of this market makes it hard to estimate its magnitude.
The total value of these transactions was more than 7.2 billion euro. The majority of trading took place in the brokered Over the Counter (OTC) market, which amounted to 207 Mt in total, a 79% share of the total OTC and exchange market (Point Carbon, 2006: p.16). The largest exchange is the European Climate Exchange, with a market share of 63% of the exchange market.
Power companies were the most active during the first three years of the developing carbon markets. Most of the power companies have extensive experience of trading in related commodities like gas, coal and power. It was a small step for these companies to add a carbon desk to their commodity trading departments (World Bank, 2006).
Figure 3 shows daily closing prices of the EUA market at the Powernext exchange. The EUAs traded mostly in a band around €20-25, in July 2005 the average EUA price spiked at €28.53. Through the end of 2005 the EUAs traded mostly above €21, before rising to €23.92 in January 2006. During February and March 2006 the average closing spot price of EUAs reached very high levels again, averaging €26.19 and €26.37. The EUA market peaked on April 18 at €29.75. The EUA market crashed on May 2 2006, when the price went to a low of €10.90 (World Bank,
2006). In early May 2006 the EU member states published the first verification (actual emissions compared to number of allowances) reports via the Community Transactions Log (CITL). The total EU ETS market appeared to be 4% long, this means that all EU installations taken together remained 4% below the total allowances level of 2.1 billion tons CO2e. The Netherlands was 6.1Mt long, Germany was 21Mt long, but the United Kingdom (36.4Mt) and Spain (9.2) were short. As can be seen in figure 3, the EUA price collapsed at the end of April 2006 because of this unanticipated long position of the total EU ETS market.
Figure 3: EUA spot market (Daily closing price, Powernext
)Source: State and trends of the Carbon market 2006, World Bank 2006
2.3 The ‘Linking Directive’
On 16 September 2004 the EU Ministers of Foreign Affairs adopted the so called ‘Linking Directive’ (Directive 2004/101/EC). This amendment to the EU ETS Directive creates the conditions to use credits generated by emission reduction projects certified by the Kyoto Protocol within the EU ETS. The European Commission recognizes CERs and ERUs as equivalent to European allowances from an environmental and economic point of view. It allows member states who obtain such credits to convert them into allowances and use or trade them within the EU ETS.16 The Linking directive aims to create more flexibility and certainty to the legal entities
within the EU ETS.
16 As explained in the Summary of the seminar on linking project-based mechanisms with the EU ETS,
Certified Emission Reductions (CERs) from CDM projects can be used in the EU ETS as of 2005, whereas Emission Reduction Units (ERUs) from JI projects can be used within the EU ETS as of 2008. The difference in treatment of both project-based mechanisms of the Kyoto Protocol is because JI projects can only be credited as of 2008, whereas CDM projects are being certified since 2000. The CERs can be banked between the first and the second phase of the EU ETS. In accordance with the Marrakech Accords the use of flexible mechanisms of the Kyoto Protocol should be supplemental to domestic action taken by Annex 1 countries. This implies that the use of CERs and ERUs for compliance by EU ETS installations should be limited. The European Commission proposed a cap of 6% of the total allocated number of allowances for the use of credits from JI and CDM projects. However, in the final version of the Linking Directive there is no limitation to the use of these credits quantified. In the National Allocation Plans for the second phase of the EU ETS each member states has to formulate its individual limitation on the use of JI and CDM credits. On a national level the cap is restrictive for each individual installation within member states.
Credits which are not eligible within the EU ETS are credits generated from nuclear, land use and land-use change and forestry (LULUCF) projects. Hydro electric power production projects need to comply with criteria laid down by the World Commission on Dams report, published in 2000. Until 2008, the transferability of CERs is limited. After issuance the CERs are stored in he buyer’s account in the CDM registry. The CERs can be transferred to the national registry of the country, for instance the Netherlands that has approved participation in the project (the forwarding of the CDM Executive Board registry to the national registry is part of the issuance). The CERs can not, then, leave the Dutch registry until 2008: compliance and transactions can take place only within the Dutch registry. This lack of transferability is caused by the delay in the establishment of the International Transaction Log. This is not only the case for the Netherlands; the same applies to the national emission registries of other EU industrial countries. For it is anticipated that the EU and its member states will have to meet the eligibility criteria for participation in the flexible mechanisms of the Kyoto Protocol in 2008. From 2008 onwards, trade in CERs between the national registries of industrial countries will be possible.17
2.3.1 Fungibility
The Linking Directive is based on a one-to-one credit conversion rate, which means that one ton of CO2-equivalent certified by the Kyoto Protocol authorities can be transferred to the EU ETS
17 Extracted from Explanatory Notes of the Interim policy for approval of participation in CDM project
for the value of one EU ETS allowance, also equivalent to one ton CO2e. This means the credits from the Kyoto Protocol are fully fungible (i.e. ‘interchangeable’) with the European allowances. 2.3.2 Obtaining CERs/Structure of CDM investments
In the early years the carbon market was dominated by third-party intermediaries such as carbon funds, emission brokers and consultants. When in 2005 a few exchange platforms and auctions emerged the carbon market started to become more transparent. The transactions are simplified, risks are reduced and price information is better available (World Bank, 2006). In this section the possible routes which EU installations can use to obtain CERs are discussed.
In literature a distinction is made between three possibilities to acquire CDM credits. Luckge and Peterson (2004) make a distinction between (1) undertaking CDM projects, (2) buying CERs from a project investor who directly undertakes CDM projects, and (3) investing in a carbon fund.
The first way how an EU installation can obtain CERs is by undertaking a CDM project by itself. If the company identifies a project it can formulate a proposal to invest in this particular project under the term of the CDM. The EU installation needs to channel the project through the CDM project cycle. This project cycle is perceived to be complex if the investor has no previous experience in the CDM. If the EU installation is part of a multinational with departments in developing countries the CDM project could be undertaken within the company.
The second option for an EU installation is to buy CERs from a third party which directly undertakes CDM projects. The third party can be an intermediary firm, such as a broker or a project developer. These parties offer the CERs to EU installations, who can use the CERs for compliance within the EU ETS. The CERs can also be transferred in a bilateral deal, i.e. a company to company deal amongst EU installations.
Governments of EU member states use CERs for achievement of their emission reduction targets of the Kyoto Protocol. Governments mostly choose to buy CERs through purchasing tenders. Governments issue these tenders for the purpose of buying CERs from project investors (Luckge and Peterson, 2004).
The third strategy to obtain a CER is through an investment in a carbon fund. EU installations and governments can participate in a carbon fund by transferring money to the fund. The money is used to finance CDM projects. The fund can also channel the project through the relevant approval and registration processes with international institutions. If these projects generate CERs, these are distributed to the participants as per their engagement in the carbon
fund. Examples of these carbon funds are the Prototype Carbon Fund (PCF), the European Carbon Fund (ECF), and the KfW Carbon Fund.18
18 The Prototype Carbon Fund established by the World Bank. The European Carbon Fund is co-sponsored
3
Theory of Financial Markets
In this section of the research a review of economic theories of financial markets tries to give an understanding of the theoretical background of arbitrage. In a broader context arbitrage will be explained by the Arbitrage Pricing Theory (APT) and the Efficient Market Hypothesis (EMH). The concept of arbitrage is defined as the simultaneous purchase and sale of the same, or essentially similar, security in two different markets for advantageously different prices (Sharpe and Alexander, 1990). Perfect arbitrage entails no risk, no capital is required, and it happens instantaneous. Arbitrage is regarded as a free lunch on the financial market. The link between arbitrage and market efficiency is made by the assumption of modern finance that the arbitrage possibilities depend on the level of market efficiency. Arbitrage causes the prices in different markets for similar or identical goods to converge. The speed of this price convergence is a measure of market efficiency.
One of the fundamentals of modern finance is dynamic spanning. This concept explored by Merton (1973) deals with the ability to exactly replicate the payoff of a complex security by a dynamic portfolio of simpler securities (Bertsimas et al., 1997). Dynamic spanning means that if you are able to replicate the payoffs of a complex security with a dynamic portfolio, the security and the portfolio must be equally priced otherwise an arbitrage opportunity exists.
Arbitrage is the underlying logic of most theories of modern finance. The option-pricing theory of Black and Scholes (1973) and Merton (1973) is based upon the concept of arbitrage. According to dynamic spanning an investor is able to replicate the payoff of an option with a portfolio of other assets. Arbitrage causes the value of the option to be equal to the value of the portfolio of other assets. Another theory that is based on the principles of arbitrage is the theorem of Modigliani and Miller (1958, 1963). When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or the individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure (Brealey and Myers, 2003). If homogeneous groups of assets with different capital structures are priced differently, investors should engage in arbitrage until any deviation in the prices are eliminated.
3.1 Arbitrage Pricing Theory
There has been extensive research on the Arbitrage Pricing Theory (APT) which was founded by Ross (1976). Ross introduced the APT as an alternative for the mean variance capital asset pricing model of Sharpe, parallel work was done by Treynor and Litner, which has become the major analytical tool for explaining phenomena observed in capital markets for risky assets. The Capital Asset Pricing Model (CAPM) of Sharpe depends on a market portfolio of risky assets. It
states that if you want to earn a higher return you need to be prepared to bear a higher risk. In a competitive market, the expected risk premium varies in direct proportion to beta (Brealey, and Myers, 2003). The basic formula of the CAPM is;
R = R f + β (Rm– Rf)
Where, R is expected return on a security Rf is the risk-free rate
Rm is the return on the market portfolio
(Rm – Rf) is the expected risk premium
β is the beta of the security
The main difference between the CAPM and the APT is that the CAPM specifies that the common risk factor is the random return on the market portfolio, whereas the APT does not prespecify the common risk factor (Cornell et al., 1989). The APT is a multi-factor model, and the CAPM is a single-factor model which works with a well-designed single factor representing all macroeconomic risks (the market portfolio). In the APT arbitrage ensures that the securities only price the systematic risk. It states that the expected risk premium on a financial asset should depend on the expected risk premium associated with each factor and the sensitivity to each of the factors (β1, β2, etc.)(Brealey and Myers, 2003). The basic formula of APT is:
R= µ + βifi +e
Where, R is the single-period random return on a security βi is the beta coefficient
fi is a factor of random variables e is a noise term
The APT is a one-period model in which every investor believes that the stochastic properties of returns of capital assets are consistent with a factor structure (Huberman and Wang, 2005). Ross argues that if equilibrium prices offer no arbitrage opportunities over static portfolios of the assets, then the expected returns on the assets are approximately linearly related to the betas. According to Chen, Roll, and Ross (1986) the expected return of the asset is a linear function of various macro economic factors like inflation, GNP, investor confidence, and shifts in the yield
curve. The beta coefficients reflect the sensitivity of the financial assets to the economic factors mentioned before. Most of these factors used in the APT are macro economic factors instead of firm specific factors. The APT prices systematic risk, so because an investor is able to diversify most of the firm specific risk factors away these are not taken into account. The idiosyncratic risk is represented by the noise factor ‘e’ at the end of the formula.
The price of a financial asset according to the APT should be equal to the sum of all future cash flows discounted by the APT discount rate. If the current price of a financial asset diverges from the price predicted by the APT model arbitrage should bring the price back to its fundamental value.
To summarize, the expected returns of securities are based on their systematic risk. The unsystematic risk is not priced, because an investor can diversify it away. The CAPM assess the risks of a security according to the market portfolio. The APT asses the risks of securities expected return with multiple macro economic risk factors. Arbitrage opportunities exist when prices are different them their fundamentals expect them to be. This arbitrage should entail identical goods, there should be no capital involved, and the purchase and sale of the securities should take place at the same time.
3.2 Efficient Market Hypothesis (EMH)
In the literature the concept of Informational Efficiency and Efficiency of Markets are used interchangeably. Efficiency in the sense of financials markets means that all information available is impounded in the market price. A modern definition is that a financial asset market is efficient if the security price ‘fully reflect all available information’ (Fama, 1991). Prices are consistent with fundamentals, because the market processes information rationally, relevant information is not ignored, and systematic errors are not made. Fama (1970) distinguishes between three different information levels which are impounded in the market price. A financial market is said to be weak form efficient if the security prices reflect all information available in previous share prices. This means that it is not possible to gain abnormal returns from technical analysis of historical price data. Second, the semi strong form efficient market is said to reflect all public available information. Finally, the market is said to be strong form efficient if the security prices not only reflect all publicly available information, but also information to which an investor might have monopolistic access. This means that if an investor has monopolistic access to information, he is not able to earn an abnormal return on his security portfolio.
In the literature on market efficiency mentioned so far all information is freely available. To be more realistic the efficient market hypothesis is adjusted by Jensen (1978). His weaker version of the hypothesis is therefore that prices reflect information up to the point where the marginal
benefits of acting on the information (the expected profit to be made) do not exceed the marginal costs of collecting the information.
The efficient market hypothesis results in predictions about the reflection of all available information in the asset prices. First, asset prices should fluctuate randomly through time in response to the unanticipated components of news (Samuelson, 1965). Second, as mentioned earlier, technical analysis provides no useful information about future asset prices. Third, an investor or a fund manager is not able to outperform the market. Finally, asset prices should rapidly adjust to new information, and currently available information cannot be used to predict future excess returns.
Imperfect information and market frictions can impede arbitrage in two different ways. First, when there is uncertainty over the economic nature of an apparent mispricing and it is at least somewhat costly to learn about it, arbitrageurs may be reluctant to incur the potentially large fixed costs of entering the business of exploiting the arbitrage opportunity (Merton (1987). It takes time for arbitrageurs to learn about the uncertainty of the arbitrage return. This uncertainty causes arbitrage opportunities to persist until arbitrageurs determine that the expected payoff is larger than the fixed costs of entering the market. Second, once the fixed costs of implementing the arbitrage strategy are borne, imperfect information and market frictions often encourage specialization. Specialization limits the degree of diversification in the arbitrageur’s portfolio and causes him to bear idiosyncratic risks for which he must be rewarded (Mitchell, 2002).
3.3 Limitations of arbitrage
The assumptions in the Arbitrage Pricing Theory and the Efficient Market Hypothesis are based on the arguments that all investors are fully rational and that there is no free lunch available at the financial markets. Behavioral finance argues that some features of asset prices are most plausibly interpreted as deviations from fundamental value, and that these deviations are brought about by the presence of irrational traders in the economy (Barber and Odean, 2001). In the analysis of arbitrage in the previous part of this chapter it is argued that a deviation from the fundamental value of a security creates an attractive arbitrage opportunity to invest in. In this paragraph the limitations of arbitrage are discussed with theories from the field of behavioral finance.
The arbitrage opportunities are in the real world limited, because strategies to correct mispricing of securities are often risky. In the literature four sources of this risk have been identified. The four sources of risk are (1) fundamental risk, (2) noise trader risk, (3) implementation costs, and (4) model risk (Barber and Odean, 2001). First, fundamental risk of arbitrage means that there is no perfect substitute for the security that is mispriced. If an investor buys a stock that is undervalued and shorts a stock that is an imperfect substitute, the investor is now vulnerable to
the idiosyncratic risk of the stock that is long in his portfolio. Even with such a substitute the investor is vulnerable to firm specific news which will cause the value of the stock to fall further. The second source of risk, noise trader risk, is caused by irrational investors. Noise trader risk is the risk that mispricing deepens in the short run. The risk of a further change of noise traders’ opinion away from its mean must be borne by any arbitrageur with a short time horizon and must limit his willingness to bet against noise traders (Shleifer, 2000). The reason noise trader risk is important, is that real world arbitrageurs have short rather than long, horizons. This is because many of the people doing arbitrage – professional portfolio managers – are not managing their own money, but rather managing money for other people (Odean, 2000). The third source of risk is the implementation costs of the arbitrage strategy. To pursue arbitrage a portfolio manager must often sell securities short to avoid fundamental risk. For some securities it is questionable if the supply of shorts is large enough to offset the demand. The implementation costs arise if the portfolio manager is not able to pursue his desired strategy because of these constraints. The last source of risk that limits arbitrage is model risk. Arbitrageurs often calculate the fundamental values of securities with asset pricing theories like the Capital Asset Pricing Model and the Arbitrage Pricing Theory. The arbitrageur cannot be sure that these models are always correct. Model risk accounts for the risk that asset pricing models are not correct. In addition to these sources of risk another limitation to arbitrage are the transaction costs of trading securities on financial markets.
4
Drivers of arbitrage between EUAs and CERs
Since the Linking Directive is adopted CERs and EUAs are considered to be fully fungible for compliance within the EU ETS. Allowances and emission credits are both accounted for in tCO2 equivalent, which makes them at first sight identical goods with the same climate change impact. There is a continuous price differential between EUAs and CERs after the Linking Directive established a link between the CDM market and the EU ETS. The EUA price consistently stood at above €20, between January 2004 and April 2005 CERs have been traded between $3 and $7.15 per tCO2 e with a weighted average of $5.63 (IETA/CF, 2005). One of the explanations for this price gap is the registration and delivery risk of CERs, but it is questionable if these risks explain the whole price gap. The price differential could also partly be explained by the transaction costs and the complexity of CDM investments.
The price differential could be exploited by EU installations if they use the less expensive CERs for their compliance, instead of EUAs. The gap is raising concerns from CDM host country project developers; they feel their emission reduction credits are undervalued. This was especially the case during the surge in the EUA price peaking on April 18 2006 at €29.75 until late April. Especially project developers in India compared the CER price with the EUA spot price during this surge.
In this chapter potential drivers of arbitrage between EUAs and CERs are identified and discussed. Potential explanations for the lack of arbitrage are (1) non transparency of the CDM market, (2) International Transactions Log, (3) risk perceptions, (4) reputational differences, and (5) the possibility of a cap on the use CERs for compliance within the EU ETS.
4.1 Non transparency of the CDM market
Confidence that the CDM mechanism will continue after the year 2012 is an important issue for investors. Ideally CDM projects would have a longer life time than the six years remaining until 2012. Hamilton (2006) considers this uncertainty as the most important issue in the CDM market. This uncertainty about post-2012 CDM results in a lack of motivation of companies to come up with new CDM project methodologies and they mainly invest in already approved methodologies. Under the assumption of risk-aversion the post-2012 uncertainty may reduce the attractiveness of CDM investments considerably. “While equity investors (e.g. those investing in carbon funds) may be more comfortable with uncertainty, banks may already be asking why they should lend against the risk that in 2012 the system will change” (Hamilton, 2006; p.41).
In a young market like the EU ETS relatively low volumes are traded. The volumes traded increase very rapidly, but if you compare these with the underlying number of allowances, the EU ETS market is far from being mature. In an immature market the prices are often volatile. It is difficult to trade on market fundamentals, because these are not yet very clear. The trade of EUAs and CERs is also characterized by informational asymmetry. As stated in section 2.2.2 a significant amount of EUA transactions and CER transactions are ‘over the counter’ (OTC) and bilateral transactions. Especially the transactions of credits from emission reduction projects are bilateral deals through brokerage firms or intermediaries. Such a market structure is characterized by a lack of transparency, because market information is difficult to obtain. The World Bank (2006) report suggests that the market could become more transparent and less volatile if EU installations would release quarterly estimates of emissions data.
Particularly the CDM market is regarded as complex and non transparent. A company needs a thorough understanding of the procedures and modalities of the CDM market. The CDM market is characterized by high risks, high transaction costs, and a long lead-time to implement a project. According to Point Carbon (2006) the increased funding of the CDM executive board has led to a streamlining of procedures. Transaction costs and risks incurred by CDM investors are supposed to be significantly reduced because of these improvements.
During 2005 and in the first quarter of 2006 the CDM market was gaining momentum. The volumes transacted increased significantly and more buyers entered the CDM market. Traditionally, the CDM market was dominated by private parties who seek emission credits for their own compliance. The World Bank (2006) categorizes new buyers into three distinct sub-groups: the first comprised of firms that were already established in the carbon finance business. These firms made investments to start carbon funds and project portfolios. The second comprised banks and financial institutions that entered into transactions on their own account and on behalf of their clients. The last sub-group comprised hedge funds, which are attracted to the bullish carbon market.
4.2 International Transaction Log
Under the Marrakech Accords a sophisticated network of linked registry systems were established for the Kyoto Protocol. This network consists of the CDM registry, the National registries and the International Transactions Log (ITL). The CDM registry and the National registries interact with the EU ETS’s Community Independent Transaction Log (CITL) through the ITL. An overview of this network of linked systems is shown in figure 6.
