Will new carbon exchange bring the yield?

Equities and bonds have been lacklustre, high-yield mortgage debt disastrous — where are investors going to find yield? Some European brokers are finding it in carbon emissions trading, and now Canadians will get their chance to participate. The Montreal Climate Exchange (MCeX) announced today that it plans to launch trading of futures contracts on Canada carbon dioxide equivalent (CO2e) units on May 30, 2008.

A joint venture of the Montréal Exchange (MX) and the Chicago Climate Exchange (CCX), the MCeX initially announced the plan to launch the carbon trading exchange in July 2007. That decision was based on an assessment of the federal government’s air pollution emissions policy released in April 2007 and following detailed consultations with potential market participants, including large industrial emitters.

The MCeX is now comfortable setting the launch date, after the government announced further details of its greenhouse gas emissions regulations, including targets for intensity-based Canadian emissions reductions and offset program terms.

U.S. research and advisory services firm TowerGroup released a report earlier this week suggesting that carbon trading markets are a high-margin solution for broker/dealers in North America who have seen their spreads decline in recent years.

TowerGroup outlines that the Kyoto Protocol helped create the path for carbon emissions trading, led by such cap-and-trade systems as the European Union Emission Trading Scheme (EU ETS).

In a cap-and-trade system, businesses are given an allowance of emissions — most commonly carbon dioxide. Under the EU scheme, if an emitter exceeds the government-mandated emissions allowance, it needs to purchase offsets and if it emits less than its allocation, it can sell the excess credits on the market to parties that need to cover their shortfall. According to TowerGroup, the EU ETS currently covers about 47% of all carbon dioxide emissions in the European Union.

Broker/dealers are a natural fit to step in and provide the liquidity in this market by selling futures. The futures value is dictated by demand and by how many credits the government allows for a given year.

Factors like economic growth, weather and the price of fossil fuels all affect the price of the carbon futures, TowerGroup points out. The single biggest factor that currently affects carbon credit value is the role of government and regulation.

For example, toward the end of April 2006, the price of a December 2008 future was €31 on the European Climate Exchange, but the EU announced it had allocated too many credits to emitters and by May 3, 2006, the price of that same contract dropped 41% to €18.25.

A sudden policy change presents a huge risk to carbon trading; however, TowerGroup says investors like U.S. hedge funds to find arbitrage opportunities by trading credits in different regions.

Luc Bertrand, president and CEO of the MX and chair of MCeX, says Canada has now presented clear regulations, making carbon credit trading viable in Canada.

“The Government of Canada has provided greater regulatory certainty regarding intensity-based emissions reduction targets and the definition of a single compliance standard for tradable credits,” he says. “This will enable emitters to more accurately forecast their individual intensity-based reduction targets and exposures.”

The MX application cites World Bank estimates that the world market for carbon amounts to about $100 billion and that recent estimated figures from market participants show that the global carbon market activity was already worth over $60 billion US in 2007.

“The demand for environmental derivatives continues to grow worldwide and the time is right to build a critical mass of trading activity in Canada,” says Dr. Richard Sandor, chairman and founder of the Chicago Climate Exchange. “MCeX products will meet demand from industrial participants to manage their emissions risks at the lowest cost while also creating continuous incentives for technological innovation that reduce carbon emissions.”

According to the MX application, CO2e unit futures contracts will be traded on the SOLA electronic trading platform. MX will settle and guarantee contracts through its clearing house, the Canadian Derivatives Clearing Corporation.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(03/14/08)

Mark Noble