Emissions trading schemes are already providing business for traders, brokers, and exchanges in the financial sector and there is market share to be won as more and more schemes are rolled out. The EU Emissions Trading Scheme (ETS) Phase II began last year, with Phase III coming on stream in 2013, and the US and UK are introducing their own cap and trade schemes. Liz Morrell looks at the incentives to go green

As governments seek to cut emissions worldwide the importance of emission trading schemes are growing rapidly, offering big opportunities for both new and existing financial players to grab a slice of the pie. The aim of such carbon cap and trade schemes is to encourage energy intensive users to take practical steps to cut carbon dioxide emissions. "The idea is to provide a limit on emissions, together with a market mechanism to encourage emissions reduction over time," explains Alessandro Vitelli, director of strategy and information services at carbon ratings agency and advisory body, IDEAcarbon. "If emitting carbon has a price, then there is an economic incentive to reduce emissions, benefiting the environment and the bottom line."

The biggest such scheme is the EU ETS which in the second quarter of 2009 was responsible for 75 per cent of emissions traded and 87 per cent of market value. It is currently in phase II of its implementation since its formation in 2005. Around 12,000 industrial installations in 27 EU member states are covered. Emissions for each installation are capped and a set quantity of EU Allowances (EUAs) - each one effectively being equivalent to the right to emit one tonne of CO2 - is given. If they emit more than their allocation more must be bought at market, while excesses can be sold. Firms can also buy carbon offsets from developing countries via the Kyoto Protocol's Cleaner Development Mechanism. A similar thing may well be present in the replacement UN Protocol, which is set to be formulated later this year in Copenhagen.

As the cap is reduced fewer allowances are available pushing prices up and prompting users to make changes to reduce their emissions. For the time-being though, there is a suspicion that too many allowances have been released, reducing the initial incentives to cut emissions.

Future growth
From next April a UK specific version of the system, the Carbon Reduction Commitment (CRC), will also be introduced. This is designed to encourage energy reductions by smaller businesses not covered by the EU ETS, such as large retailers, and will also include a league table and penalties for those not complying. Like the EU ETS allowances will be traded. Although more than 5,000 UK businesses will be affected, very few yet realise the implications. Research sponsored earlier this year by document imaging vendors Kyocera Mita, amongst SMEs, showed 21 per cent of respondents did not even know what CRC was and less than a fifth of respondents could actually say for sure if they would be exempt. Part of the confusion is no doubt due to a lack of clarity about the scheme itself, although this is expected to be alleviated by the government when it outlines its plans more fully towards the end of the year.

Globally, the emissions trading market has grown rapidly. In 2008 it doubled to an estimated value of more than US$126 billion, according to the latest State and Trends of the Carbon Market Report, published by the World Bank at the end of May. Research and market data firm, New Energy Finance (NEF), says the carbon market will reach $360 billion by 2012 and if the US introduces its own cap and trade scheme, as expected, it could rise to $1.9 trillion by 2020.

Patrick Birley, chief executive of a leading exchange for carbon, the European Climate Exchange (ECX) which is based in London, says that his business has grown rapidly. "In the first year (2005) we traded 95 million tonnes of carbon," he says. "Those figures have escalated since - to 450 million tonnes in 2006, one billion tonnes in 2007, three billion in 2008 and a forecasted six to seven billion tonnes this year. In terms of exchanges lots of venues have products in this area, but so far we have been the most successful in getting business and have a market share of around 98 per cent of all derivative trading options," he claims.

How does it work?
The market - though complex - is relatively simple to emulate, especially for those already trading other commodities. Carbon is traded in exactly the same way as gold or anything else. "ECX and other carbon-based exchanges are no different from the London Derivatives Exchange or the Stock Exchange," says Birley. Indeed the ECX business runs on the electronic trading platform of ICE Futures Europe - one of the largest oil and gas exchanges in the world. The technology and general processes are the same.

IDEAcarbon's Vitelli says there are a number of opportunities for traders, brokers and exchanges: "Such a large market will need a variety of financial and other service providers - for example, investors to help build low-carbon projects in the developing world, financial players to provide liquidity in the traded carbon market and to help companies access the market itself (thereby establishing a transparent price for carbon), and exchanges to offer a low-cost forum for the trading to take place and to auction allowances to the market on behalf of governments. Technology companies will be needed to supply carbon accounting equipment, trading platforms, risk management systems, or to carry out carbon emissions verification at emitting installations, plus a whole host of firms will be needed to ensure that projects and carbon accounting meet the very strict regulatory criteria."

Guy Turner, director of carbon markets at NEF, says the increasing scope of the EU ETS, which from 2012 will also include the aviation industry, means the opportunities will only increase. "With relatively few abatement opportunities in the aviation sector this presents a new type of buyers for carbon credits. Establishing early relationships with these firms will be useful for future business," he says.

Others are more cautious about the opportunities. "The market has definitely grown but the entire year's carbon trading is still just a bad day on the bonds market - it's not that large a cake," says Keiron Allen, communication and marketing director at BlueNext, an environmental exchange based in Paris that was formed in February last year and uses Trayport technology systems for its trading platform.

The market will become more concentrated, believes NEF's Turner. "Whether there is sufficient demand for more exchanges and brokers is questionable," he says. "In our opinion there is more likely to be consolidation, rather than expansion in the number of exchanges." There are new entrants coming in however. "As volumes rise that offers opportunities for others to get involved and we are seeing interest from commodity traders and new people coming into the market," counters ECX's Birley.

The UK is trying to establish itself as the hub. "The UK is well-prepared and already leads the world in carbon trading," says IDEAcarbon's Vitelli. "The largest carbon exchange of all (ECX) is based in London, almost all the major trading companies, banks, brokers and service providers are also here, including clearing houses." Barclays claims to have been the first UK bank to set up a dedicated carbon trading desk in 2004 with its Barclays Capital division and has traded over two billion tonnes of carbon. The likes of JP Morgan and Deutsche Bank have also moved in, mainly via their London operations. BlueNext in Paris and other exchanges and brokers across Europe will also however fight for a slice of the pie.

Technology
So what technology is needed to enter the market? ECX's Birley says many of the underlying technical principles are the same. "If people are currently trading any other commodity product, then their existing technology structure is likely to be the same," he says. It's a point that James Davies, head of trader systems at the vendor Trayport, agrees with: "If users are already utilising our platform to trade electricity, then most would be able to migrate across to use it for carbon," he says.

IDEAcarbon's Vitelli believes there will be some new build IT projects. "Some new technology is needed, especially at the physical end of measuring emissions," he says. "Perhaps the US will see more new build projects, such as registry systems, but by and large, the template has been built, and in my view will simply be refined." The carbon market in Europe is almost five years old already he points out and well established.

Five years is still, however, an immature market. "We are only a few years into a system that is going to be around for several generations and for which only Europe and five industry sectors - mainly industrial - are presently covered," says ECX's Birley. "As other countries and regions introduce their own caps there will be huge opportunities."

In such a growing market some changes are inevitable, agrees Trayport's Davies, even if the core mechanisms stay the same. "When comparing this with other markets, carbon hasn't been around all that long, so we should expect a number of additional evolutions before we see the long-term shape. Whoever generates these new ideas and brings them to market first can expect to be rewarded with market share."

There are risks to be aware of though. As with any new product, companies need to understand the offering, how the instruments operate, and the customer's needs. We've seen what happens when financial instruments aren't properly understood with the credit crunch, which was largely caused by CDOs, MBSs, CDSs, and other investments that not everyone understood sufficiently well enough to ensure stability. IT heads shouldn't get complacent either, otherwise disintermediation awaits. The benefits of scale will also come into play with ECX, for example, likely to be quite hard to displace as it already enjoys significant liquidity in this area. As Davies notes, "there are some really competent people in this marketplace and you can't just come in and be average. You need to differentiate."

Conclusions
Carbon trading is growing fast and the introduction of the CRC is likely to lead to a secondary market for carbon management and trading in the UK as those involved struggle to get to grips with their new obligations. The recession has had an impact on price - dropping from a 30 Euro peak on the EU ETS, to just eight Euros in February this year - as falls in manufacturing and production during the recession have meant less power being used. The volume of trades doesn't appear to have been affected and the effect of the downturn will only be temporary.

Long-term the market is set for growth. The results of the Copenhagen Climate Change Summit in December 2009, where a successor to the Kyoto Protocol will be negotiated, and also where the US cap and trade scheme may begin to finally take shape, will also provide another stimulus for carbon trading. Once that happens it is expected the boom in trading will be even bigger. Those financial players that are already prepared and waiting, stand to gain enormously.

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